The Markets in Financial Instruments Directive (MiFID) has been described as “an elephant in the room that no one has noticed”. Whilst the p...

The Markets in Financial Instruments Directive (MiFID) has been described as “an elephant in the room that no one has noticed”. Whilst the pachyderm has now emerged from the shadows, the window of opportunity is shrinking rapidly for the cultural and infrastructural change required to comply with MiFID. The impact of the directive will be felt across the financial services industry and will lead to significant changes to the operating and execution models for wealth managers, family offices and private banks. Given the scale of the change proposed by the directive the need to commence preparations as soon as possible is clear. The objective of MiFID is to create an integrated pan-European financial market in which investors are effectively protected whilst safeguarding the efficiency and integrity of the overall market. The directive lays the foundation for future change under the Financial Services Action Plan. Under MiFID common regulatory requirements will be established relating to investment firms authorised within the European Union. The directive will govern the function of regulated markets and other trading systems to prevent any disruption in one or more markets spreading to the wider European financial system. The directive is due to be adopted into national law by EU member states in October 2006 and firms will need to be compliant with the requirements by April 2007. The national regulators and trade bodies are currently defining the technical measures required to implement the directive. The FSA has suggested that complying with the directive will require significant systems and infrastructure change which will impose significant costs on financial services firms. Cultural and Infrastructural Changes There are several main changes mandated by MiFID that will impact the wealth management community. For the first time, a set of common conduct of business rules will apply. This will include the requirement for firms to apply a standard classification to their customer base. In addition, they will have to conduct a full suitability test on clients when they are providing investment advice or portfolio management. Under certain circumstances, it is possible for private individuals to request an exemption from the protection offered under the conduct of business rules, i.e. to be treated as a professional investor and to transact on an execution only basis. In order for a client to be treated as a professional investor, the firm must carry out an assessment of the expertise, knowledge and experience of the client. Best execution will be redefined under MiFID in terms of best trading result for the customer in the context of their portfolio. The manager will be required to undertake post-trade analysis to ensure that the executed trade is compliant with the published policy and to guarantee that the policy delivers the best result for the client. The directive also requires the firm to demonstrate the capability of its IT systems and operational processes to support ongoing business; ensure continuity and regularity of service; and facilitate the reporting and controls mandated by the directive. This coupled with the requirement to demonstrate compliance (and that action is being taken to address breaches) will drive firms towards a greater integration between processes, people, and data. The transparency requirement demands that the volume and price at which listed equity orders were executed be published at the point of execution and that previously hidden liquidity should be exposed. It is not yet clear whether this part of the directive will be applied to buy side firms. Pre- and Post-Trade Compliance The major impact of MiFID for the wealth management community will be felt in pre- and post-trade compliance activity, as it will give an extra focus to the question of best execution for the client. Within this context the investment manager should:

• Publish a policy regarding trade execution and be able to demonstrate compliance with this policy.
• Access all reasonable points of liquidity in accordance with the published policy
• Carry out a pre-trade analysis to assess the impact of the trade including: market impact; price; implementation risk; depth of liquidity; transaction costs; and settlement risk.

This set of requirements will place a major strain on the infrastructure and processes for wealth managers with regard to pre-trade analysis wherein the manager must ensure compliance with the stated execution policy and that the proposed execution is “best for the client”. These may only be possible via manual processes. Post trade, the manager will be required to assess whether the execution delivered the best result for the client. This review will need to include an assessment of the factors in the selection of a particular market or broker. The directive also requires that the investment manager retain records relating to transactions sufficient to allow the regulator or their representative to ensure compliance with the directive. The delivery of information for the pre or post trade compliance checks to the right desktop on a timely basis is a key requirement. In order to achieve compliance the firm may need to redesign their processes, removing the old barriers between the “front”, “middle” and “back” office and seeking to manage the trade lifecycle of each product in an integrated way. Based on the potentially wide scope and impact of the changes required wealth managers should begin to plan for these changes now if they have not already done so. Phil Kitto is a senior wealth management consultant at Citisoft, an investment management consulting firm. Citisoft services cover all aspects of the investment management lifecycle: from front to back office including: strategic planning and change management; system selection and implementation; outsourcing selection, implementation and transition management.